Angela Merkel is the biggest threat to Europe's recovery

It may sound a little strange with Germany leading the way on
positive economic data surprises in recent months but the biggest
risk to Europe's nascent recovery remains Chancellor Angela
Merkel's government.

Why, you might well ask?

Well while the pace of growth in Germany is to be welcomed, and
particularly the fact that it is appears to be finally feeding
into wage gains for German workers, the country's history of
chronic inflation phobia could yet scupper hopes of a sustainable
recovery in the region.

The problem is as follows: Since the onset of the euro crisis the
economies of member states have been diverging. This was
initially reflected in bond spreads between the so-called core
countries (think Germany, France, Austria, the Netherlands etc.)
and peripheral states (Greece, Italy, Spain, Portugal and
Ireland):

However, it is currently best illustrated by comparing the
spread between unemployment rates:

The key point to note is that high unemployment is generally
considered a good reason to think that an economy has room to
grow at a relatively rapid pace without causing inflation to rise
to worrying levels. Low unemployment suggests that an economy is
operating close to its potential, meaning that an increase in the
rate of growth would likely mean that prices would start being
pushed up.

And that's a problem for Europe. In Germany and Austria,
unemployment is hovering around levels that economists tend to
consider the "natural rate", where further drops would likely
imply higher wage growth (as employers have to offer more money
to entice workers) and rising prices. By stark contrast,
unemployment in Spain and Greece remains above 20% — an
extraordinarily high level that implies an uptick in growth would
have very little impact on average wages.

Such large differences between countries would normally result in
very different central bank interest rates. Within the monetary
union, however, they are all reliant on rates set by the European
Central Bank, which means that during periods of economic
divergence (as we have now) policy is likely to be too tight for
the weakest economies and too loose for the strongest.

Higher wages are good news for German consumers, but they will be
equally welcomed by struggling states in Europe's periphery as
stronger German demand could provide a boost to exports and
reduce the competitive advantage that lower labour costs have
given to German products and services. Yet to realise these
benefits, Merkel's government will have to allow inflation in the
country to rise — potentially even above the ECB's target of
"close to but below 2%".

Bringing on a housing bubble?

Jens Weidmann, president
of the German Bundesbank and a member of the European Central
Bank (ECB) Governing Council.REUTERS/Brian
Snyder

And there are serious risks to this strategy. Between 1998 and
2001 the Clinton administration also decided to run a budget
surplus in the face of very strong investor demand for safe
government bonds. Some academics argue that by doing so and
shrinking the outstanding stock of government debt the US
government played a part in inflating a housing bubble as
investors began channelling funds that would have gone to
government bonds into mortgage securities.

The bubble ultimately burst in 2008 with devastating
consequences.

While we are unlikely to see exactly the same scenario play out
in Europe, extremely low yields on safe government debt could
well start to channel investment into other higher-yielding (and
at least notionally "safe") assets such as property in core
countries.

Already Germany’s
central bank president Jens Weidmann has been warning that
property prices in the country are showing signs of being
overvalued, although he stopped short of calling it a bubble. He
told an audience in Munich, according
to The Wall Street Journal:

"Bundesbank calculations suggest that by now in cities there are
clear overvaluations [in residential real estate]. We reckon that
prices are between 10% and 20% above the levels that are
fundamentally justified. In the hip neighbourhoods of big cities,
the overvaluation may be more.”

Worrying times
ahead...

REUTERS/Michaela Rehle

With the ECB undertaking asset purchase programmes, the cost of
credit in large, growing economies like Germany is only likely to
fall from here. That in turn suggests that, in the absence of
direct government intervention, the prices of a range of assets
(including property) could well continue to rise.

This is clearly a
concern for Weidmann.

So what can the government do about it? In theory it could decide
to increase taxes, for example on property transactions, in order
to drain money from the economy and prevent it from overheating.
However, it would have to manage the results very carefully.

If the state chose to use the tax windfall to swell its coffers
even more it might help to cool domestic demand somewhat.
However, it would also be likely to exacerbate the contraction of
government bond supply as demand for Bunds fails to drop at the
same rate as the debt is being paid down. At least some of this
money could be driven into the very asset classes that the state
is trying to cool, worsening the problem rather than resolving
it.

Moreover, even if it were to succeed in cooling German economic
growth and inflation it would mean that the gap between the core
and the periphery would last for longer. If growth fails to pick
up elsewhere in the region the ECB could be compelled to continue
or even increase its QE programme to bring inflation back towards
target causing the cycle to start all over again.

A more positive alternative scenario is that the government could
try to soak up the additional investment demand through issuing
bonds. If it used even a portion of those funds to invest in
struggling peripheral European economies (either directly or
through increasing funding of supranational investment funds) it
could help increase growth across the region, helping to bring
those economies back into line with Germany and reducing the
pressure on itself to take the burden of adjustment.

Unfortunately, there is precious little evidence that German
policymakers are even willing to consider such a strategy.
Without it, however, Merkel and her government remain the biggest
risk to the prospects of a European recovery.